Reagan-style stimulus unlikely to work now

Julie Heath, the director of the UC Economics Center at the College of Education, Criminal Justice and Human Services at the University of Cincinnati. She also holds the Alpaugh Family Chair in Economics.(Photo: JP Leong)

Reducing government regulations. Increasing defense spending. High-income tax cuts. Although these are proposals of both Presidents Ronald Reagan and Donald Trump, any similarities would vanish in implementation.

Reagan became president as the economy was headed into a recession – the unemployment rate was 7.5 percent when he took the oath and shot up to 10.8 percent in 1982. When Trump entered the Oval Office, the unemployment rate was 4.7 percent. This difference is important because any stimulus spending that Reagan enacted had a lot of room to run before it bumped up against the potential for inflation.

When Reagan took office, the federal funds rate (the interest rate at which banks lend to other banks) was 19 percent. Then-Fed Chair Paul Volcker kept rates high to combat inflation. These high rates led to the recession of 1981-2, and as the Fed cut rates by half over the following two years, this relatively cheap money led to massive increases in investment spending, providing significant stimulus to the economy. As a result, GDP growth reached 7.3 percent in 1984.

In contrast, the current federal funds rate (0.75-1.00 percent) reflects a gradual increase from near-zero to provide continuing stimulus to the economy post-recession. Paradoxically, this starting point for interest rates will prove to be problematic for the administration if economic growth materializes.

President Donald Trump speaks at Rivertowne Marina in Cincinnati Wednesday, June 7, 2017.(Photo: The Enquirer/Meg Vogel)

The success of the administration’s budget rests on two things: stimulus spending (tax cuts, military and infrastructure spending) and the projected effect on GDP (minimum of 3 percent growth). The challenge presented by stimulus spending in the current economic environment is that the Fed will hike interest rates when this stimulus spending starts overheating the economy, in turn dampening the very growth the spending is intended to spur.

The challenge presented by relying on 3 percent GDP growth to fund this fiscal stimulus lies in our demographics. That level of growth could only be achieved, by definition, by the country producing more output. We can only produce more output if we have more workers and/or our existing workers are more productive. In 2016, population growth in the U.S. was 0.7 percent, the lowest since the 1930s. The labor force participation rate is continuing its decades-long decline as Baby Boomers exit. Immigration is a possible countermeasure to the reduction in native-born workers, but current policies preclude that remedy.

That leaves increased productivity as the engine of GDP growth. Not likely. Productivity has been declining for some time, frustrating economists and policymakers alike, looking for explanations. Even if the supply-side argument is to be believed – reducing marginal tax rates lead to increased productivity – when Reagan entered office, the highest marginal tax rate was 70 percent, compared to the current highest level of 39.6 percent. Again, Trump has much less room for similar policies to have an effect.

Reaganonomics and Trumponomics are similar fiscal stimulus packages. The problem is that the current economy offers significant headwinds to the successful implementation of such stimulus. Applying the same fiscal tools in a different environment and expecting the same result is, to put it mildly, unlikely to succeed.

Julie Heath is the director of University of Cincinnati Economics Center at the College of Education, Criminal Justice and Human Services.